Lesson Title: Simple Interest and Compound Interest

UNIVERSITY OF THE EAST - MANILA

Discussion
Simple Interest and Compound Interest

Simple interest method:

Under this method, the interest is charged only on the amount originally lent (principal amount) to the borrower.
Interest is not charged on any accumulated interest under this method. Simple interest is usually charged on
short-term borrowings.

Simple interest formula:

Simple interest can be easily computed using the following formula:

Where;

 I = Simple interest in dollars

Compound interest method:

Compounding of interest is very common. Under this method, the interest is charged on principal plus any
accumulated interest. The amount of interest for a period is added to the amount of principal to compute the
interest for next period. In other words, the interest is reinvested to earn more interest. The interest may be
compounded monthly, quarterly, semiannually or annually. Consider the following example to understand the
whole procedure of compounding.

Compound amount and compound interest formula:

The above procedure of computing compound amount and compound interest is lengthy and time consuming.
Fortunately, the formulas are available to compute compound amount and compound interest for any number
of periods.

(i). Compound amount formula:

Where;
Lesson Title: Simple Interest and Compound Interest
 A = Compound amount
 P = Principal amount
 i = rate of interest
 n = number of periods

(ii). Compound interest formula:

Compound interest = Compound amount – Principal amount

Compound interest is greater than simple interest:

Compound interest is greater than simple interest. The reason is very simple. Under simple interest system,
the interest is computed only on principal amount whereas under compound interest system, the interest is
computed on principle as well as on accumulated interest. Consider the following example for the explanation
of this point:

EXAMPLES

Example 1:

A loan of $10,000 has been issued for 6-years. Compute the amount to be repaid by borrower to the lender if
simple interest is charged @ 5% per year.

Solution:

P = $1,000; i = 5%; n = 5

By putting the values of P, i and n into the simple interest formula:

I=P×i×n

= $10,000 × 5% × 6

= $10,000 × .05 × 6

= $3,000

At the end of sixth year, the amount of $13,000 ($10,000 principal + $3,000 interest for six years) will be repaid
to the lender.

Example 2:

Suppose, you have deposited $100 with a bank for five years at a rate of 5% per year compounded annually.
The interest for the first year will be computed on $100 and you will have $105 ($100 principal + $5 interest) at
the end of first year. The interest for the second year will be computed on $105 and at the end of second year
you will have $110.25 ($105 principal + 5.25 interest). The interest for the third year will be computed on
$110.25 and at the end of third year you will have $115.76 (110.25 principal + 5.51 interest). The following
table shows the computation for 5-year period of investment.
Lesson Title: Simple Interest and Compound Interest

Under compound interest system, when interest is added to the principal amount, the resulting figure is known
as compound amount. In the above table, the compound amount at the end of each year have been
computed in the last column. Notice that the compound amount at the end of a year becomes the principal
amount to compute the interest for the next year.

Example 3:

The City Bank has issued a loan of $100 to a sole proprietor for a period of 5-years. The interest rate for this
loan is 5% and the interest is compounded annually. Compute

1. compound amount
2. compound interest

1. Computation of compound amount:

A = P(1 + i)n

= $1,000 × (1 + 5%)5

= $1,000 × (1 + .05)5

= $1,000 × (1.05)5

= $1,000 × 1.276

= $1,276

2. Computation of compound interest:

Once the compound amount has been computed, the amount of interest earned over the investment period
can be computed by subtracting principal amount from the compound amount. In this example, the principle
amount is $1,000 and the compound amount computed above is $1,276. The amount of compound interest for
the fiver year period can be computed as follows:
Lesson Title: Simple Interest and Compound Interest
Compound interest = Compound amount – Principle amount

= $1276 – $1,000

= $276

Use of future value of $1 table to compute compound amount:

The shortest and easiest method to compute compound amount is to use the future value of $1 table. This
table contains the value of (1 + i)n for a given value of i and n. After locating the value of (1 + i)n in the table,
the principal amount is simply multiplied with the value to find the compound amount. The principal amount is
then subtracted from compound amount to get the amount of compound interest for the given interest rate and
time period.

= $1,000 × (1 + 5%)5

= $1,000 × 1.276*

= $1,276

Compound interest : $1,276 – $1,000 = $276

*Value of (1 + 5%)5 from future value of $1 table: 5 periods; 5% interest rate.

The future value tables are widely used in accounting and finance to save time and avoid unnecessary
computations.

Example 4:

A woman has deposited $6,000 in a saving account. Bank pays interest at a rate of 9% per year.

Required: Compute the amount of interest that will be earned over 12-year period:

1. if the interest is simple?

Solution:

(1) Simple interest:

= $6,000 × 0.09 × 12

= $6,480

(2) Compound interest:

= $6,000 × (1 + 9%)12

= $6,000 × 2.813*

= $16,878

Compound interest = $16,878 – $6,000

Notice that compound interest is more than simple interest by $4,398 ($10,878 – $6,480).

*Value of (1 + 9%)12 from future value of $1 table: 12 periods; 9% interest rate.

ACTIVITY:

Solve each of the following problems and show your solutions.

1) Find the interest on a used car loan of $5000 at a rate of 16% for a period of 8 months.

2) Find the interest earned on an investment of $10,000 into a money market account that pays a
simple interest rate of 1.75% over a 39 wk period.

3) Find the amount due on a loan of $600 at 15.75% interest after 21 months.

4) A loan of $2500 was repaid at the end of 39 weeks with a check for $2812.50. What annual rate of
interest was charged?

5) An accountant for a corporation forgot to pay the firm’s income tax of $725,896.15 (uh-oh) on time.
The government charged a penalty of 12.7% annual interest for the 34 days the money was late. Find the total
amount that must be paid.

6) Jessie buys 100 shares of stock at $29.52 per share and then sells the stock 9 months later at
$37.85 per share. Transaction fees are 1% of the total transaction. What annual interest rate did Jessie earn?
Lesson Title: Simple Interest and Compound Interest
7) How long will it take for a CD to double, if money earns a simple interest rate of 4.8%? Round up
nearest year.

8) How much should you deposit initially in an account paying 10% compounded semiannually in order
to have $1,000,000 in 30 years? b) compounded monthly? c) compounded daily? d) continuous compounding
Semi-annual Answer

Monthly Answer

Daily Answer

Continuous Answer

9) You have $7,000 toward the purchase of a $10,000 automobile. How long will it take the $7000 to
grow to the $10,000 if it is invested at 9% compounded quarterly? (Round up to the next highest quarter if
not exact. Always round UP to the next period unless it comes out to an exact value. The reason for this is
money is only compounded at each period.) Make sure you solve this using logarithms.
Lesson Title: Simple Interest and Compound Interest